A fresh approach to equity diversification
Henry Cobbe CFA, Investment Director at Elston Consulting, looks beyond regional equity diversification to consider sectors, factors and themes.
The most traditional approach to world equity diversification is a regional approach. This gives investors the ability to overweight or underweight particular markets, on the outlook of their economies.
Whilst this is straightforward, cheap and aligned with fund sector classifications, it is restrictive and increasingly dated.
A lot of what drives share price performance is based on which sector they are in (Energy stocks are having a great time now, Consumer Discretionary less so), the factors that drive their returns (Value is currently outperforming growth), or long-term structural themes (like food production or cyber security).
Indeed many managers talk sectors, factors or themes, but invest by region. This doesn’t make much sense. So sector, factor and thematic exchange traded funds (ETFs) can help.
How do we differentiate between these categories?
Sectors group companies by their business activity. These industry classifications are long-standing and relatively stable enabling research as regards sector performance in different economic regimes.
Factors group equities with similar style characteristics. Factors are the broad persistent explainers of return explored in academia. Examples of factors include value (companies whose price is cheap relative to their fundamentals), size (small cap vs large cap), quality (higher return on equity (ROE) and gross margin), momentum (companies with rising share prices) and minimum volatility (less volatile share prices).
Themes group companies by exposure to a structural long-term theme that could act as a tailwind for growth. Examples of themes include food security, cyber security, medical cannabis & life sciences, to name a few.
By allocating according to sectors, factors, or themes, investors can capture investment style while minimizing idiosyncratic risk.
What are the options?
- Sector ETFs: State Street Global Advisors offer 11 world equity sector ETFs. For example, SPDR MSCI World Health Care UCITS ETF (LSE:HEAW). Physical replication, 0.30% TER, largest holding of 142 is United Health Group Inc (7.34%).
- Factor ETFs: iShares offers 5 main world equity factor ETFs, for example iShares Edge MSCI World Value Factor UCITS ETF (LSE:IWVF) provides exposure to a sub-set of world equities on low valuations relative to their fundamentals. Physical replication, 0.30% TER, largest holding of 397 is Intel Corp (2.19%).
- Thematic ETFs: Rize offers 8 thematic ETFs focused on structural themes. Their largest is Rize Sustainable Future of Food UCITS ETF (LSE:FOGB) which focuses on sustainable food producers in any geography. Physical replication, 0.45% TER, largest holding of 43 is SIG Combibloc Group (4.94%)
Sectors, Factors and Themes offer a more coherent grouping of companies than the region of their headquarters. This provides a more nuanced way to implement tactical views and a more targeted approach to equity diversification.
All ETFs mentioned are London-listed ETFs and available on the IG trading platform.
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